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Know Your 401(k) Plan’s Rules


I recently got hooked on a board game called “Pegs and Jokers.”

If you’ve never played it before the simplified explanation would be you are trying to get all your “pegs” around the board before your opponents do. And the “Joker” card is a really good card to have.

It’s a game of chance of course. If you get a bad hand it can be hard to win the game.

But it’s also a game of skill. You have to play your hand wisely. And save up different good cards for just the right time.

There are so many little rules in this game that you must know. If you forget just one rule, then your opponent can exploit that and cause you to lose.

And when it comes to your 401(k) plan, there are a lot of little rules that you may be unaware of. Playing the 401(k) “game” without knowing the rules can lead to some problems down the road. And dare I say, the stakes are much higher with your 401(k) than they are with a board game.

How to get money out of your 401(k)

Sometimes it can be difficult to get your money out of a 401(k). These are retirement accounts, so they are created to be used at a later phase of your life.

If you are in your 40’s or early 50’s, you may be surprised that you can’t get funds out of your 401(k) unless you have some type of qualified hardship situation.

In most circumstances, you have to wait until you reach 59 ½ before being able to pull funds from your 401(k).

You may be saying, “What if I’m willing to pay a penalty? Can I get the funds out earlier than age 59 ½?”

The answer is: Under most circumstances no.

If you are working for your employer and are under the age 59 ½ you can’t pull the funds out of your 401(k) unless it is classified as a hardship distribution.

If you leave your employer you will then have the option to roll the old 401(k) into an IRA. At that point you could get the funds out. NB: You may pay a 10% IRS penalty if you do it before age 59 ½, but at least you’d have access to it.)

A lot of people don’t realize this when they start making 401(k) contributions. And this doesn’t necessarily mean 401(k)’s are bad. There are so many upsides to them, such as tax deferral and employer match.

But it’s just how they work. And you need to know the rules.

401(k) In-service withdrawals at age 59 ½

But all of that changes when you reach age 59 ½. At that age you may be able to do an “in-service withdrawal.”

I say “may” be able to do it. Most 401(k) plans allow this at 59 ½. But you may have a plan with one of the few that do not allow in-service withdrawals at that age. Check with your plan before doing anything.

So what is an “in-service withdrawal?”

It is simply a distribution you make from your 401(k) while you are still in the service of your employer. You have to be at least 59 ½ to do this. If you are younger than that, no deal.

And you can even keep tax deferral going on the funds by rolling them into an IRA account. In fact, that’s probably the best decision for most people.

Otherwise, if you don’t roll them into an IRA, the withdrawals will count as taxable income that year. Imagine the taxes you’d pay if you took a $400,000 distribution that was counted as income all in one year.

Ouch!

And it goes without saying that you’d probably be in a higher marginal tax bracket that year!

So taking an in-service withdrawal that rolls directly into an IRA, keeps the tax deferral going. And the withdrawn 401(k) funds won’t count as income to you that year as long as they go into your IRA.

Remember what 401(k) plans are for

You may be saying, “I don’t like all these rules! I lose too much flexibility with my money!”

And I understand. But keep in mind what the purpose of the 401(k) account is. It is for retirement planning. That’s why the rules are put in place to restrict your ability to get access to the funds before age 59 ½.

Also, keep in mind the advantages. You can contribute more to a 401(k) each year than you can to an IRA. This allows you to lower your current taxation since it lowers your current taxable income.

Also, there is the employer match. This is free money for you.

The downsides are of course you have less convenient access to your funds.

That’s why it’s good to have some of your investments outside of retirement accounts (like 401(k)’s or even IRA’s). You need funds for liquidity and emergencies.

Conclusion

As long as you understand the rules you can “play the game” more effectively.

If you are ready to make an in-service withdrawal and rollover your 401(k) funds to an IRA, then be sure to check out the 401(k) rollover 10-point checklist.

Cheers!

401K Plan Rules


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